1929 meet 2008

There are many comparisons in recent newspapers between the crash of 1929 and the crisis of 2008. The media of today has not settled on a consistent title for America’s current events but “Crisis” appears to be the most common caption among the newspapers I see.

Many books and articles have been published on the stock market crash of 1929, but one book in particular stands out as short, only 197 pages, readable and relevant for today’s debacle. It is The Great Crash, by John Kenneth Galbraith.

After using newspaper and other accounts he describes what happened in journalistic fashion with a final chapter titled Causes and Consequence. The first cause on his numbered list is “The Bad Distribution of Income.”

Allow me a brief quote.

In 1929 the rich were indubitably rich. … The proportion of personal income received in the form of interest, dividends and rent – the income broadly speaking of the well-to-do – was about twice as great as in the years following the Second World War.

This high unequal distribution of income meant that the economy was dependent on a high level of investment or a high level of luxury spending or both. The rich cannot buy great quantities of bread. If they are to dispose of what they receive it must be on luxuries or by way of investment in new plants and new projects.

Mr. Galbraith was writing 50 years ago about events of nearly 80 years ago, but it is helpful for man of his distinction to confirm what is the underlying cause of America’s crash of 2008: the bad distribution of income.

The growing inequality of income is well documented in the Federal government’s publication of the Current Population Survey. In their table of Selected Measures of Household Income Dispersion the highest 10 Percent of household income continue to gain income share year by year on the bottom 10 percent, but also the bottom 20, 50 and 80 percent of households.

The wealthy pay the same price for bread, eggs and milk as everybody else which is why they have extra money to speculate in Wall Street’s new and exotic investment derivatives: hedge funds, collateralized debt obligations, mortgage and asset backed securities, principal only strips, credit default swaps and so on.

In the mean time heavily taxed wages are going up slowly, but not as fast as prices, a reality documented by the Bureau of Labor Statistics. More of us are reaching credit card limits and home equity loan limits. Refinancing mortgages for cash, or lower interest rates, did provide a boast to buying power, but these too are running low.

A mass society needs mass participation, which the unequal distribution of income limits. The crisis of 2008 tells us the wealthy have failed to return their savings and tax cuts back into the economy in a constructive way to create long lived assets and jobs. They have failed themselves and the country. It is time for the wealthy to pay more tax.

Dividends and Taxes

In 2007 someone starting out in their twenties with a modest $30,000 a year salary will be expected to pay $5,091.25 in federal income and payroll taxes. For a single person who earns the same $30,000 as dividend income the total federal tax would be $1,062.50.

For a married couple starting out where both earn $30,000 a year salary, they pay federal tax of $10,182.50. For a married couple who earns the same $60,000 as dividend income they pay $2,125 in total federal tax. There is no payroll tax on dividend income.

This extraordinary favoritism toward corporate dividends has been going on since 2003. It not only debases work but changes America’s saving and consumption. A couple starting out in their twenties will be unlikely to have dividend income, but their very high taxes make it difficult to save anything, or buy a house.

Those with dividend income since 2003 are likely to be older with years of saving and a nest egg of savings and dividend income. Likely as well, they already own a home. Their lucrative tax breaks have generated savings for them and loanable funds for banks and financial intermediaries.

Apparently they all forgot that savers earn a return only if borrowers who can pay back their loans. The millions of sub prime mortgages and the rapid and large number of foreclosures and defaults make it clear those who are starting out and many others cannot afford to buy a home, or borrow all those loanable funds.

There was a comment in one of my previous posts where a reader suggested Congress and the Bush administration has been pushing sub prime loans to boast home ownership for political reasons. I am sure that is correct and recent testimony and discussion in the Wall Street Journal confirms that view.

It is the same Congress and Bush Administration that promoted tax breaks for dividends and ignores the income inequality their policies help to generate. It makes no difference what any one says about fairness in taxes. America has to raise taxes on the wealthy and give tax relief to working Americans, or the economy will continue to flounder and decline.

Bailout

I have talked with many people about last week’s bailout; they are all angry. Some that I have talked with were complete strangers who started in ranting and raving at the newsstand and several at my neighborhood library. In my unscientific poll it is unanimous: everyone regards the bailout plan as a payoff to politically connected cronies who caused the defaults. Many recognize there are better alternative plans.

For the federal government to buy the current defaulted mortgage backed securities has enormous potential for abuse. Salomon brothers got the idea to bundle home mortgages together and re-sell them as bonds back in the 1980’s. They call these bonds various things like collateralized debt obligations or mortgage backed securities, but they are not the same as bonds at all.

For example, if I buy a $10,000 municipal bond at 5 percent for a term of 10 years, I get $250 every six months and after 10 years I get my $10,000 back. If I need money before the 10 year term is up I can sell my bond. If the interest rate is up I will have to accept less than $10,000 because potential buyers know they can earn 6 percent instead of 5.

To sell my bond I will have to discount the price so that $250 twice a year will earn a 6 percent yield. If I sell after 5 years with a 6 percent interest rate, then $250 twice a year and a $10,000 final payout will sell at $9,573.* A home mortgage all by itself is like a bond because it has known payment and maturity dates, which make it possible to determine the yield at any time. Mortgage backed securities are many mortgages all bundled together as a lump sum and then divided into smaller but different parts to be resold to investors.

Trouble is the underlying mortgage holders can prepay at anytime and for investors who have mortgage backed securities that contain many mortgages there is no way to know when prepayments will come. Mortgage backed securities were marketed by selling them at a discount over the total of their final payout. It is just that the date of the final payout could not be specified. Without a known maturity date or a known number of payments a yield cannot be determined, but only guessed at as a gamble.

Any transaction of these securities will be a negotiation between sellers who do not know for sure what they are selling and a government that does not know for sure what it is buying. It is a situation ripe for cronyism and abuse.

Congress has the authority to ban the use of securities without a known yield, instead they did nothing but decide to buy them. It looks like a bad deal for savers and taxpayers.

*[Computations are Excel functions YIELD("1/1/2004","1/1/2009",0.05,95.735,100,2,1) also FV(0.06/2,10,250,-9573.5,0)]